One way to search for potentially undervalued firms is by using the ratio levered free cash flow/enterprise value. Companies with high ratios may be undervalued. We have used this technique below.
To further identify the best value among our universe of undervalued companies we did additional screening for the most profitable stocks beating their industry peers on trailing twelve months gross, operating, and pre-tax margins.
Let's explore this idea and how it works.
We start with the concept of levered free cash flow.
Levered free cash flow is the free cash flow available to common shareholders after paying interest on outstanding debt. Debts include taxes, repayments on debts, and any expenditures to maintain or expand business (capital expenditure or capex). In other words, levered free cash flow is the cash flow available to shareholders, since debtholders are always paid first.
This number is very important because unlike earnings or income statements, which can be easily tweaked, it is very hard to manipulate cash flow.
Calculating levered free cash flow is simply: (Cash flow from operations) – (Capital expenditures)
Enterprise value is an alternative measure of a company's value (instead of using market cap). Enterprise value is the sum of the firm's value from all ownership sources: market cap, outstanding debt, and preferred shares. From this value, we subtract cash holdings because, in the event of a takeover, that cash would be used toward the takeover price.
To better understand this, consider enterprise value as the cost of taking over a company, calculated as market cap plus debt and liabilities minus cash. For example, if Company A were to buy 100% of Company B, it would need to buy all the outstanding shares, the value of which is the market cap. Company A would then be stuck with any debts and liabilities that Company B had. But Company A would also get all of the cash that Company B had in the bank, which would help pay off the debts, etc.
Together we get the levered free cash flow to enterprise value ratio (LFCF/EV). It is one method of measuring the value of a company. The more free cash a company has relative to its enterprise value (a high ratio), the cheaper the company appears.
When the ratio of levered free cash flow to market cap is high, it may indicate that the price is too low. At the very least, it indicates that the company is producing a lot of cash.
Using the LFCF/EV ratio can ultimately help investors identify potentially undervalued names.
Next we explore the profitability metrics:
Trailing 12 months (TTM): An indication that the calculated data has come from the last 12 months. For example, if data released in July 2045 is "TTM" (i.e., P/E TTM or "Trailing P/E"), this means the price and the earning-per-share data comes from the 12-month period of August 2044 to July 2045.
TTM Gross margin: This metric that tells us the percentage of a company's revenue is left after paying all production expenses. Costs include overhead, payroll and taxation. ((revenues-cost of goods sold) / Revenue ) *100 = Gross margin %
TTM Operating margin: This tells us the percentage remaining after all operating expenses are paid. Operating expenses include: supplies, repairs, research and development, and depreciation. (Operating Income / Net Operating Revenue) *100 = Operating Margin %
TTM Pre-tax margin: A company's earnings before taxes. This incorporates all of the expenses associated with business excluding taxes. It can help to determine the overall operating efficiency of the firm. The higher the pre-tax margin, the more profitable the company. (Net profit before taxes / net sales) *100 = Pre-tax Margin
Ready to go? Here's our list of 10 highly profitable companies with loads of cash. (Click here to access free, interactive tools to analyze these ideas.)
List compiled by Eben Esterhuizen, CFA:
1. Artio Global Investors
2. HCC Insurance Holdings
6. Time Warner
7. Primoris Services
8. Gladstone Investment
9. Apollo Group
10. Cellcom Israel
Interactive Chart: Press Play to compare changes in analyst ratings over the last two years for the stocks mentioned above. Analyst ratings sourced from Zacks Investment Research.
Kapitall's Eben Esterhuizen and Rebecca Lipman do not own any of the shares mentioned above.
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